Tuesday, March 03, 2009

The unfortunate uselessness of most ’state of the art’ academic monetary
economics, by Willem Buiter: The Monetary Policy Committee of the Bank of
England I was privileged to be a ‘founder’ external member ... contained, like
its successor..., quite a strong representation of academic economists and other
professional economists with serious technical training and backgrounds. This
turned out to be a severe handicap when the central bank had to switch gears and
change from being an inflation-targeting central bank under conditions of
orderly financial markets to a financial stability-oriented central bank under
conditions of widespread market illiquidity and funding illiquidity.; Indeed, it
may have set back by decades serious investigations of aggregate economic
behaviour and economic policy-relevant understanding .; It was a privately and
socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the
New Classical rational expectations revolution associated with such names as
Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the
New Keynesian theorizing of Michael Woodford and many others) have turned out to
be self-referential, inward-looking distractions at best.; Research tended to be
motivated by the internal logic, intellectual sunk capital and esthetic puzzles
of established research programmes; rather than by a powerful desire to
understand how the economy works - let alone how the economy works during times
of stress and financial instability.; So the economics profession was caught
unprepared when the crisis struck.

Complete markets

The most influential New Classical and New Keynesian theorists all worked in
what economists call a ‘complete markets paradigm’. In a world where there are
markets for contingent claims trading that span all possible states of nature
(all possible contingencies and outcomes), and in which intertemporal budget
constraints are always satisfied by assumption, default, bankruptcy and
insolvency are impossible. ...

Both the New Classical and New Keynesian complete markets macroeconomic
theories not only did not allow questions about insolvency and illiquidity to be
answered.; They did not allow such questions to be asked. ...

[M]arkets are inherently and hopelessly incomplete.; Live with it and start
from that fact. ... Perhaps we shall get somewhere this time.

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory
(and to aggregative macroeconomics in general), the strongest version of the
efficient markets hypothesis (EMH) was maintained.; This is the hypothesis that
asset prices aggregate and fully reflect all relevant fundamental information,
and thus provide the proper signals for resource allocation.; Even during the
seventies, eighties, nineties and noughties before 2007, the manifest failure of
the EMH in many key asset markets was obvious to virtually all those whose
cognitive abilities had not been warped by a modern Anglo-American Ph.D.
education.;; But most of the profession continued to swallow the EMH hook, line
and sinker, although there were influential advocates of reason throughout,
including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph
Stiglitz and behaviourist approaches to finance.; The influence of the heterodox
approaches ... was, however, strictly limited.

In financial markets, and in asset markets, real and financial, in general,
today’s asset price depends on the view market participants take of the likely
future behaviour of asset prices.; ... Since there is no obvious finite terminal
date for the universe..., most economic models with rational asset pricing imply
that today’s price depend in part on today’s anticipation of the asset price in
the infinitely remote future. ...; But in a decentralised
market economy there is no mathematical programmer imposing the terminal
boundary conditions to make sure everything will be all right. ...

The
friendly auctioneer at the end of time, who ensures that the right terminal
boundary conditions are imposed to preclude, for instance, rational speculative
bubbles, is none other than the omniscient, omnipotent and benevolent central
planner.; No wonder modern macroeconomics is in such bad shape. ...; Confusing
the equilibrium of a decentralised market economy, competitive or otherwise,
with the outcome of a mathematical programming exercise should no longer be
acceptable.

So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no
Auctioneer at the end of time.

Linearize and trivialize

If one were to hold one’s nose and agree to play with the New Classical or
New Keynesian complete markets toolkit, it would soon become clear that any
potentially policy-relevant model would be highly non-linear, and that the
interaction of these non-linearities and uncertainty makes for deep conceptual
and technical problems. Macroeconomists are brave, but not that brave.; So they
took these non-linear stochastic dynamic general equilibrium models into the
basement and beat them with a rubber hose until they behaved.; This was achieved
by completely stripping the model of its non-linearities and by ...
mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset
prices in illiquid markets and the funding illiquidity of financial institutions
exposed to these asset prices through mark-to-market accounting, margin
requirements, calls for additional collateral etc.; will appreciate what is
lost...; Threshold effects, non-linear accelerators - they are all out of the
window.; Those of us who worry about endogenous uncertainty arising from the
interactions of boundedly rational market participants cannot but scratch our
heads at the insistence of the mainline models that all uncertainty is exogenous
and additive.

Technically, the non-linear stochastic dynamic models were linearised (often
log-linearised) at a deterministic (non-stochastic) steady state.; The analysis
was further restricted by only considering forms of randomness that would become
trivially small in the neigbourhood of the deterministic steady state.; Linear
models with additive random shocks we can handle - almost !

Even this was not quite enough...; When you linearize a model, and shock it
with additive random disturbances, an unfortunate by-product is that the
resulting linearised model behaves either in a very strongly stabilising fashion
or in a relentlessly explosive manner.; ... The dynamic stochastic general
equilibrium (DSGE) crowd saw that the economy had not exploded without bound in
the past, and concluded from this that it made sense to rule out ... the explosive solution trajectories.; What they were left with
was something that, following an exogenous; random disturbance, would return to
the deterministic steady state pretty smartly.; No L-shaped recessions.; No
processes of cumulative causation and bounded but persistent decline or
expansion.; Just nice V-shaped recessions.

There actually are approaches to economics that treat non-linearities
seriously.; Much of this work is numerical - analytical results of a
policy-relevant nature are few and far between - but at least it attempts to
address the problems as they are, rather than as we would like them lest we be
asked to venture outside the range of issued we can address with the existing
toolkit.

The practice of removing all non-linearities and most of the interesting
aspects of uncertainty from the models ... was a major step backwards.; I trust
it has been relegated to the dustbin of history by now in those central banks
that matter.

Conclusion

Charles Goodhart, who was fortunate enough not to encounter complete markets
macroeconomics and monetary economics during his impressionable, formative
years, but only after he had acquired some intellectual immunity, once said of
the Dynamic Stochastic General Equilibrium approach which for a while was the
staple of central banks’ internal modelling: “It excludes everything I am
interested in”. He was right.; It excludes everything relevant to the
pursuit of financial stability.

The Bank of England in 2007 faced the onset of the credit crunch with too
much Robert Lucas, Michael Woodford and Robert Merton in its intellectual
cupboard.; A drastic but chaotic re-education took place and is continuing. ...

I think this is right, but I'd put it differently. Models are built to answer
questions, and the models economists have been using do, in fact, help us find
answers to some important questions. But the models were not very good (at all)
at answering the questions that are important right now. They have been largely
stripped of their usefulness for actual policy in a world where markets simply
break down.

The reason is that in order to get to mathematical forms that can be solved,
the models had to be simplified. And when they are simplified, something must be
sacrificed. So what do you sacrifice? Hopefully, it is the ability to answer
questions that are the least important, so the modeling choices that are made
reveal what the modelers though was most and least important.

The models we built were very useful for asking whether the federal funds
rate should go up or down a quarter point when the economy was hovering in the
neighborhood of full employment ,or when we found ourselves in mild, "normal"
recessions. The models could tell us what type of monetary policy rule is best
for stabilizing the economy. But the models had almost nothing to say about a
world where markets melt down, where prices depart from fundamentals, or when
markets are incomplete. When this crisis hit, I looked into our tool bag of
models and policy recommendations and came up empty for the most part. It was
disappointing. There was really no choice but to go back to older Keynesian
style models for insight.

The reason the Keynesian model is finding new life is that it specifically
built to answer the questions that are important at the moment. The theorists
who built modern macro models, those largely in control of where the profession
has spent its effort in recent decades,; did not even envision that this
could happen, let alone build it into their models. Markets work, they don't
break down, so why waste time thinking about those possibilities.

So it's not the math, the modeling choices that were made and the inevitable
sacrifices to reality that entails reflected the importance those making the
choices gave to various questions. We weren't forced to this end by the
mathematics, we asked the wrong questions and built the wrong models.

New Keynesians have been trying to answer: Can we, using equilibrium models
with rational agents and complete markets, add frictions to the model - e.g.
sluggish wage and price adjustment - you'll see this called "Calvo pricing" - in
a way that allows us to approximate the actual movements in key macroeconomic
variables of the last 40 or 50 years.

Real Business Cycle theorists also use equilibrium models with rational
agents and complete markets, and they look at whether supply-side shocks such as
shocks to productivity or labor supply can, by themselves, explain movements in
the economy. They largely reject demand-side explanations for movements in macro
variables.

The fight - and main question in academics - has been about what drives
macroeconomic variables in normal times, demand-side shocks (monetary policy,
fiscal policy, investment, net exports) or supply-side shocks (productivity,
labor supply). And it's been a fairly brutal fight at times - you've seen some
of that come out during the current policy debate. That debate within the
profession has dictated the research agenda.

What happens in non-normal times, i.e. when markets break down, or when
markets are not complete, agents are not rational, etc., was far down the agenda
of important questions, partly because those in control of the journals, those
who largely dictated the direction of research, did not think those questions
were very important (some don't even believe that policy can help the economy,
so why put effort into studying it?).

I think that the current crisis has dealt a bigger blow to macroeconomic
theory and modeling than many of us realize.

When asked if what Buiter says is true, Brad DeLong says:

Brad DeLong: Yes, it is true. That is all.

Well, actually, that is not all. Buiter is a little bit too mean to us "new
Keynesians", who were trying to solve the problem of why it is that markets seem
to work very well as social planning, incentivizing, and coordination mechanisms
across a range of activities and yet appear to do relatively badly in the things
we put under the label of "business cycle." I, at least, always regarded Shiller,
Akerlof, and Stiglitz as being fellow "New Keynesians." As Larry Summers put it
to a bunch of us graduate students l around the end of 1983, Milton Friedman's
prediction in 1966 that the post-WWII economic policy order would break down in
inflation had come true and that that had given the Chicago School an enormous
boost, but that now they had gone too far and were vulnerable, and that our
collective intellectual task if we wanted to add to knowledge, do good for the
world, and have productive and prominent academic careers was to "math up the
General Theory": to take the conclusions reached by John Maynard Keynes in his
General Theory of Employment, Interest and Money, and explain how or demonstrate
to what degree they survived the genuine insights into expectations formation
and asset pricing that the Chicago School had produced. In fact, Buiter's column
I read as a commentary on General Theory chapter 12: "The State of Long-Term
Expectation." Collectively, I think we made a compelling intellectual case--but
we were completely ignored and dismissed by Chicago.

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"The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics"

Willem Buiter on "'state of the art' academic monetary economics":

The unfortunate uselessness of most ’state of the art’ academic monetary
economics, by Willem Buiter: The Monetary Policy Committee of the Bank of
England I was privileged to be a ‘founder’ external member ... contained, like
its successor..., quite a strong representation of academic economists and other
professional economists with serious technical training and backgrounds. This
turned out to be a severe handicap when the central bank had to switch gears and
change from being an inflation-targeting central bank under conditions of
orderly financial markets to a financial stability-oriented central bank under
conditions of widespread market illiquidity and funding illiquidity.; Indeed, it
may have set back by decades serious investigations of aggregate economic
behaviour and economic policy-relevant understanding .; It was a privately and
socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the
New Classical rational expectations revolution associated with such names as
Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the
New Keynesian theorizing of Michael Woodford and many others) have turned out to
be self-referential, inward-looking distractions at best.; Research tended to be
motivated by the internal logic, intellectual sunk capital and esthetic puzzles
of established research programmes; rather than by a powerful desire to
understand how the economy works - let alone how the economy works during times
of stress and financial instability.; So the economics profession was caught
unprepared when the crisis struck.